Predictably Irrational Chapter 2 – The Fallacy Of Supply And Demand

In chapter 2 of Dan Ariely’s fantastic “Predictably Irrational”, he discusses how supply and demand are not the independent forces that drive prices in the market as usually described. Instead consumers are subject to anchoring and arbitrary coherence which nudges them towards higher or lower prices. Our first impressions have a large effect on later decisions so that too an extent, the market drives the consumer not the other way around. As Tom Sawyer discovered, people pay a high price for what is hard to get regardless of its supply or demand curve.

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Back in the 1970s Salvador Assal (who had made a fortune through selling pearls) was approached by Jean-Claude Brouillet who had come across a collection of black pearls in Polynesia. Assal agreed to sell them even though there was no market at the time for black pearls. However, his efforts were a failure and he didn’t make a single sale. At this point the neo-classical economist would argue that the market had spoken and should be respected. Consumers didn’t want black pearls so he should give up (only the government would be ignorant enough to force their will upon the market) or at least sell them at a discount price.

Instead he used his contacts to have the black pearls placed in the windows of a jewellery store on Fifth Avenue with a ridiculously high price tag. He took out large ads in glossy magazines presenting black pearls alongside diamonds and rubies. These black pearls which had been near worthless and sold only on obscure Polynesian islands were now worn by the most prosperous and famous of Manhattans elites. The trick was that if the pearls had been treated like cheap jewellery sold in a discount store, that’s all they would have been. But by treating them like rare and exclusive commodities they became status symbols of the wealthy.

This is all to do with anchoring. You see people cannot decide things in absolute terms, rather they compare it to others (see yesterdays post on relativity). So a consumer cannot decide if $5 is a good price without comparing it to others. So they take a price as an anchor or a starting point. But what Ariely found was that the original anchor had a large impact on consumer’s later choices. If people are given a low anchor, they will bid low and vice versa. Although it seems strange, simply asking people to think of a low number (thereby anchoring them to a low number), makes them put a low value on a good and simply asking someone to think of a high number makes them more willingly to pay a higher price.

Ariely tested this idea with an experiment where he asked people the final digits of their social security number (say 79) and asked if they would be willing to bid that price for a bottle of wine (in this case $79). After they answered, they would then actually bid for the bottle in a genuine auction. Surely it’s ridiculous that simply thinking of a high number would make them bid higher, right? Wrong, that’s exactly what happens. People whose last two digits were between 80-99 bid $27.91 dollars on average, while those whose last two digits were between 00-19 bid $8.64. Simply making someone think of a higher number makes people willing to pay treble the price.

This is called arbitrary coherence as the initial price is randomly chosen (arbitrary) and in turn affects future prices (coherence). To make sure he was drawing the right conclusions he added five extra items to the auction (composed of 55 students from MIT’s School of Management so these were smart and savvy future business people), another bottle of wine, a cordless trackball, a cordless keyboard and mouse, a design book and some chocolate. In every case, those who had higher social security numbers were willing to bid double or treble those with lower numbers and this was gradual throughout the levels (those with numbers between 40-59 bid more than those between 20-39). As this was a real auction where they had to pay for the goods which they got to keep and because a social security number is a random number given to every citizen, this shows that the market is not governed by rational individuals pushing towards ever efficient outcomes, but rather by people who are easily swayed and manipulated in predictably irrational ways.

(The auction was still logical in that the book cost more than the chocolates and the keyboard cost more than the trackball. The students hadn’t lost their senses; merely their starting point was manipulated leading to a different end point. There is nothing special about social security numbers; any number could have been used.)

The first time we buy something that becomes our anchor for future purchases. It has been found that people who move cities in America tend to pay the same amount for an apartment despite the different price levels of the cities. Their old rent is an anchor of what they think an apartment should cost and they stick close to it.

Ariely conducted a further experiment where students were be subject to a 30 second clip of annoying sounds and asked how much they would have to be paid to listen to the sounds again. The first group was asked if they would accept 10 cent and the second group 90 cent. After answering the question they were asked what was the lowest price they would accept to agree to listen to the sounds again. As there is no market in annoying sounds, the initial offers acted as an anchor. The 10 cent group on average asked for 33 cent to listen to the sounds again, while the 90 cent group asked for more than double this, 73 cent. So far the same result as the last experiment, but Ariely wanted to know how long did the anchoring effect last?

Both groups were given another noise and offered 50 cent to listen to it again. Again the 90 cent group requested a higher price than the 10 cent group. They were anchored to a high price and seeing as the sounds were similar, they charged similar prices. Ariely added another step by asking if the 10 cent group would accept 90 cent to listen to a sound and the 90 cent group if they would accept 10 cent. So each group had three possible anchors (10, 50 and 90 cent) and were then allowed to start bidding. He found that the original anchor still dominated. The group that had been offered 10 cent first still accepted low offers despite being suggested 90 cent. The original anchor held for future prices as well as present ones.

Ariely added a further twist to the tale. He read a poem to his students and then told them he would do poetry readings of varying lengths (short, medium and long). He asked half his students if they would hypothetically agree to listen to him if they were paid $10 and the other half if they would pay him $10 for the honouring of listening to him. They were then left to bid for each section. Those who had been offered money, offered on average $1.30 for a short poetry reading, $2.70 for a medium and $4.80 for the long reading. Interestingly those who had been asked if they would pay Ariely offered a dollar for the short, about two dollars for the medium and just over three dollars for the long reading. The initial offer not only anchored how much they would pay but also whether they would pay or be paid.

The importance of these studies is best summed up by Ariely himself:

“All this talk about anchors and goslings has larger implications than consumer preferences, however. Traditional economics assumes that prices of products in the market are determined by a balance between the two forces: the production at each price (supply) and the desires of those with purchasing power at each price (demand). The price at which these two forces meet determine the prices in the marketplace.

This is an elegant idea, but it depends centrally on the assumption that the two forces are independent and that together they produce the market price. The results of all the experiments in this chapter (and the basic idea of arbitrary coincidence itself) challenge these assumptions. First according to the standard economic framework, consumers’ willingness to pay is one of the two inputs that determine market prices (this is the demand). But as our experiments demonstrate, what consumers are willing to pay can be easily, and this means that consumers don’t in fact have a good handle on their own preferences and the prices they are willing to pay for different goods and experiences.

Second, whereas the standard economic framework assumes the forces of supply and demand are independent, the type of anchoring manipulations we have shown here suggest that they are, in fact, dependent. In the real world, anchoring comes from manufacturer’s suggested retail prices (MSRPs), advertised prices, promotions, product introductions, etc. – all of which are supply-side variables. It seems then that instead of consumers’ willingness to pay influencing market prices, the causality is somewhat reversed and it is market prices themselves that influence consumers’ willingness to pay. What this means is that demand is not, in fact, a completely separate force from supply.”

14 thoughts on “Predictably Irrational Chapter 2 – The Fallacy Of Supply And Demand”

  1. Ariely is great. I recommend though to try William Poundstone’s “Priceless”, and Kahneman’s “Thinking, fast and slow”. Poundstone’s book is especially interested in price setting and the underlying psychological processes (anchoring, arbitrary coherence, psychophysics etc.), while Kahneman, who is somewhat of a celebrity in psychology, invented the heuristics and biases research (with Amos Tversky).

    1. I have heard of Kahnemann and Tversky who along with Ariely are the Holy Trinity of Behavioural economics and it is due to them that we know most of what we know. “Thinking Fast and Slow” is on my to read list as I’ve heard its supposed to be great. I’ve never heard of Poundstone but I will try to check him out.

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